What are Deferred Expenses?
Deferred expense is the expense which has already been paid for by the company in one accounting year but the benefits for such expenses have not been consumed in the same accounting period and it is to be shown in the asset side of the balance sheet of the company.
The dictionary meaning of the word “defer” is to put off to a later time, or to postpone. With that in mind, we can simply say that deferring an expense means postponing the expenses. But this activity of postponing the expense does not mean the expense is not made. Instead, the postponing is done in reporting of that particular expense.
Deferred Expenses Examples
Example #1 – House Rent Expense
Let us assume that student A is living in a rented house costing him INR 10000 per month. In the month of June, he has extra cash of INR 20000 with him and hence, decides to pay the rent in advance for the next two months. In other words, he has already paid for the service (occupying the rented house) which he will consume (living in the house) in the coming months.
For the next two months, the expenditure of INR 20000 made will serve as an asset to the student as it is providing him with benefits. If the student were to record this advanced rent payment transaction of INR 20000 in his accounting books, he will label it as this “expenses” and the same will appear as an asset on his balance sheet entries.
A month later from now, the “deferred expenses” head will be reduced from INR 20000 to INR 10000. This is because out of two months of advances payment made, one-month service has already been availed. Now the asset is available only for next month and worth only INR 10000. Hence, the reduction in this “expenses” head. And accordingly, entry of 10000 will be made in “expense” head as per double-entry booking accounting standards.
- We can extend the idea of the expenses to financial statements of companies as well. The core idea to remember is that anything for which a company has already paid-out and is now “entitled” to receive services, therefore, are recorded as “deferred expenses” and not “expenses” due to the difference in timing of consumption of that service.
- Formally, the term “deferred expenses” is used to describe a payment that has been made, but it won’t be reported as an expense until a future accounting period. These expenses are reported on the balance sheet as an asset until it expires.
Example #2 – Consultancy Fee
A corporation is into manufacturing of handbags and shoes. They are planning to install a new manufacturing unit and have hired consultants and lawyers for doing due-diligence and making legal contracts. Let us assume that the life of this new manufacturing unit is going to be 10 years. The consultation and legal fees total an amount of INR 2500000.
The company will make an entire payment of INR 2500000 at the beginning of the project, i.e. the beginning of year 1. But it will not enter this amount entirely in “expenses” head. Rather, it will “defer” the INR 2500000 to balance sheet accounts such as new project costs. The company will charge INR 250000 (INR 2500000 spread over 10 years) of the new project costs to expenses each year.
The reason why total expense is recorded as “deferred expenses” is because it provides better treatment of matching the total expense of INR 2500000 to each period (here, each period is a year unlike the above example where each period was a month) where they will be using the newly installed production unit and earning revenues from it.
Another example can be seen in insurance premium payments.
Example #3 – Insurance Premium
The insurance premium is paid in advance in return for accidental coverage in coming months or years.
For instance, Company A pays the insurance premium for its office building. Premium payment is half yearly. The total cost of insurance is INR 80000. Payments are made in June and December, every year. In June, the company will pay INR 40000 for the insurance coverage it receives until December. Rather, it has repaid in June an amount of INR 40000 for the service (insurance protect) it will consume over the next six months until next due date for payment approaches. In this example, the company will record the deferred expense of INR 80000 as the asset in the first year and as an expense in the second year of accounting.
Deferred Expense vs Prepaid Expense
- While “deferred expenses” are sometimes also referred to as “prepaid expenses”, there is a fine difference in those terms. Strictly speaking, the two terms cannot be used interchangeably.
- When the time duration of deferment in less than a year, i.e. when the advance payment is made for future periods falling within a year, the expense is labeled as “prepaid expense”. While when the future payments are for periods longer than one year, it is labeled as “deferred expenses”. The reason for this lies in the categorization of assets.
- As we have already learned that prepayment of expenses is considered as an asset for reporting purposes. When the asset created is for less than a year, it is termed as the current asset and is reported as “prepaid expense. Similarly, when the asset created is going to last for more than one year, it is termed as noncurrent (long-lived) asset and is reported as “deferred expenses”.
Deferred Expenses Video
This has been a guide to what is Deferred Expenses. Here we discuss deferred expenses examples of House Rent Expense, Consultancy Fees, and Insurance Fees. Also, we discuss the differences between pre-paid expense vs deferred expense. You may also learn more about accounting from the following recommended articles –
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- Deferred Revenue Examples for Journal Entry
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- Deferred Revenue Examples | Top 4
- Explanation of T Accounts
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